Government’s strategy is ambiguous on arbitrating between reform and growth

Environmental problems

Risk assessment

Further slowdown in 2016

The Chinese economy is expected to continue slowing in 2016. The authorities are implementing reforms needed to rebalance growth in favour of consumption and services. This is however hitting the profits of weak companies. Despite the ongoing monetary easing since November 2014 and the expansionary budget measures, investment is likely to remain limited in 2016. As companies are heavily indebted and several sectors are facing large overcapacities, the monetary relaxation is proving ineffective and the volatility of the financial markets could undermine confidence levels of among investors and consumers. In this context, disposable income should rise slowly and household consumption is likely to slacken somewhat. Despite the very rapid expansion in online sales, retail sales are losing momentum.

Although there was a rise in property prices in the main cities in 2015, the construction related sectors are likely to remain flat because of high inventory levels. A collapse in the housing market is however not very likely, as the authorities have the capacity to intervene in the event of a severe shock. The growth of the services sector, in particular financial, is also continuing.

Exports are however expected to continue suffering the weakness of global demand. Nevertheless downward pressures on the yuan could improve the competitiveness.

The credit risk of companies is increasing

Although the level of public debt is sustainable, that of local municipalities is high (at around a third of GDP) and remains opaque.

In addition, corporates are highly indebted and the expansion of shadow banking makes it very difficult to evaluate. In September 2015, the debt of the private sector accounted for 205% of GDP. On top of this and despite the monetary policy easing, SMEs frequently have to rely on shadow banking at exorbitant rates, given their difficulty in securing financing.

In this context there has been a gradual decline in the quality of banking assets which are also under-estimated because of the scale of shadow banking. The official ratio of non-performing loans reached 1.75% during the first quarter 2016, its highest level since 2009. Together with “Special mention loans”, this ratio reached 5.76%. The credit risk has increase significantly, highlighted by the growing number of defaults on the Chinese bond market. While China experienced its first default in 2014, 24 companies (a third of State owned enterprise’s) defaulted on the bond market during the first quarter 2016. The introduction of real bankruptcy risk is inevitable and will reduce moral hazard generated by government interventions. In the context of the economic slowdown, the solvency of more fragile borrowers will still need to be monitored in 2016

Following a rise of more than 110% between November 2014 and June 2015, the Chinese stock markets recorded a significant correction during summer 2015. Stock exchanges lost more than 43% in less than 3 months. In the beginning of 2016, the benchmark index lost 17% before stabilizing. Volatility is also high on the foreign exchange market. Admittedly this market correction can be seen as a healthy development after such a sharp rally disconnected from corporates’ fundamentals, volatility have generated additional risks. The heavy use of margin finance (investors borrow money to buy shares) has increased the credit risk and could worsen the downwards spiral.

Business climate continues to suffer shortcomings

Whilst reaffirming the supremacy of the Chinese Communist Party (CCP), the Central Committee session of the CCP in October 2014 concluded with decisions relating to an improvement in the state of law. In addition, the 5th plenum of the Communist Party, which was held in October 2015, ended the one child policy and reaffirmed the desire on the part of the authorities to develop the social protection system. However, the national security reform project has caused concern among some NGOs and foreign investors. Despite a seamless transition from the previous administration, President Xi Jinping wields unprecedented authority over the CCP, particularly following the anti-corruption campaign which targeted the highest-ranking party dignitaries. However, the Xi Jinping – Li Keqiang administration is facing both social and ethnic unrest. The country has seen an increasing level of worker activism which caused the authorities to publish a guide on the development of “harmonious work relations”. Finally, major shortcomings in term of governance persist, particularly concerning access to company balance-sheets and legal protection for creditors.